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Dow Jones Industrial Average component Bank of America (BAC - Free Bank of America Stock Report) is one of the largest commercial banks in the U.S. as measured by assets, with operations in all 50 states and the District of Columbia, and in over 40 foreign nations. The 2007-2009 period was especially turbulent for the banking behemoth and, although some things may be starting to turn around, the company faces additional challenges in the next couple of years. By mid-decade, however, long-term investors may be rewarded with a doubling or more of the stock price, as Bank of America puts the problems of the past few years behind it, and as better economic activity and growth initiatives position the company for a partial earnings recovery.

A Brief History

The company we now know as Bank of America was formed when NationsBank acquired the former BankAmerica in September, 1998. The former BankAmerica traces its roots to 1904, when Amadeo Giannini established the Bank of Italy to serve immigrants in San Francisco. The company, which eventually changed its name to BankAmerica, made numerous acquisitions over the years of regional institutions, like Seattle-based Seafirst Corp. in 1983.

Meanwhile, North Carolina-based NationsBank also had its roots in a bank established many years ago that eventually became North Carolina National Bank, or NCNB, and later, NationsBank. In the 1990s, under its then chairman Hugh McColl, the company expanded in the southeastern U.S. via acquisitions of regional players like Florida-based Barnett Banks and other financial services firms. Then, in the fall of 1998, NationsBank acquired BankAmerica, extending its presence coast to coast, and renaming itself Bank of America. The company’s current chief executive officer, Brian Moynihan, took the helm in early 2010.

A Diverse Business Mix

Bank of America divides its operations into five business groups. The Consumer Banking segment provides a range of products for consumers and small businesses through its branch network, ATMs, nationwide call centers, and mobile banking platforms. Consumer Real Estate Services segment’s products include mortgages and home equity loans. The Global Banking division lends to businesses and provides treasury services. The aforementioned business lines should benefit meaningfully as the economy recovers. A large contributor to the bottom line in the past few years, but probably the most volatile of the six business lines, is Bank of America’s Global Markets division, which  includes the fixed-income, currency and commodities, equities, and investment banking businesses. Lastly, the Global Wealth & Investment Management segment is a relatively steady and profitable performer.

At The Center Of The Storm

Given its size and the breadth of its operations, it’s unlikely that Bank of America would have been able to sidestep a lot of the problems that have beset the bank industry since 2007, and the company has taken a lot of heat for its missteps. Its nonaccrual loans and credit costs ramped up quickly in 2008 and 2009, following the onset of the recession, the housing market collapse, and the company’s mid-2008 acquisition of Countrywide Financial, which was a big subprime mortgage lender. Since the start of 2008, Bank of America has been an active participant in mortgage modification programs. In the past few years, concerns regarding mortgage loan documentation have arisen, both on the part of mortgage securities holders and home loan borrowers. Bank of America has had to purchase mortgages sold to government-sponsored entities (like Freddie Mac) and other mortgage investors. In recent years, Bank of America has also had to mark down or take losses on collateralized debt obligations and other risky exposures. Too, lawsuits filed by shareholders and others have proliferated, some related to the early 2009 acquisition of troubled Merrill Lynch, pushing up expenses. Meanwhile, excluding acquisitions, loan balances have been eroded by weak demand for credit, loan charge-offs, and the runoff of some of Countrywide’s portfolio.

Bank of America accepted an initial $25 billion of bailout funds in the fall of 2008, in the form of preferred stock sold to the government under the TARP (Troubled Assets Relief Program), followed by another $20 billion in January of 2009 to help it close the acquisition of Merrill Lynch, which experienced significant losses in late 2008. Bank of America also sold additional common stock and slashed its common stock dividend, first in half and later to a nominal quarterly rate of a penny a share, in an effort to further bolster its equity capital position. In late 2009, the company was able to repay the $45 million, thereby eliminating the drag on earnings per share of the costs ($900 million per quarter of preferred dividends) of the government aid.

Still Sizable Near-Term Challenges

Bank of America still faces a number of big problems. The housing market remains largely frozen, making it hard to resolve delinquent mortgage loans and ensuring that more mortgage investors will present the company with repurchase claims. The numbers are daunting, and although the company seems to be making progress resolving mortgage repurchase claims, it’s unclear how long the process will drag out. The magnitude of ultimate costs of efforts to resolve the mortgage problems are also uncertain.

Additionally, various financial reform measures are taking a big bite out of Bank of America’s revenues, including a reductions in its service charge, credit card, and debit card income. The reform measures are being phased in and it probably will take a few years for the company to offset their negative effect on revenues with changes in the way customers are charged for bank services. These factors, in addition to continued uneven economic activity, probably will limit Bank of America’s earnings progress in the next year or two, in spite of further declines in its problem loans and credit costs.

The View To Mid-Decade Looks Better

Given the company’s current problems, it would be easy to underestimate its long-term potential. But Bank of America is gradually approaching the point, we figure within our 2014-2016 investment time frame, when its credit costs fall back to normal, lower levels, reflecting changes in its lending practices and stronger economic activity; when the company eventually finds ways to offset the revenue lost due to recent financial reform measures; when better economic activity boosts loan demand; when a steeper yield curve supports a wider net interest margin and a pickup in net interest income; and when Bank of America’s legal and mortgage repurchase expenses moderate. Additionally, the acquisition of Merrill gives Bank of America the opportunity to sell bank products to Merrill customers who don’t bank with Bank of America and to sell Merrill’s investment products to Bank of America customers who don’t invest with Merrill. And the company is working to lower its expense ratio, partly via workforce reductions. In 2011, it launched its New BAC program that aims to lower costs by $5 billion by 2014.

If things go Bank of America’s way, even moderate earnings improvement should support a decent, though partial, recovery in the stock price over the pull to 2014-2016 from the issue’s currently depressed level. Meanwhile, the company expects to meet new equity capital standards without selling additional common stock.  An increase in the dividend on the common stock is probably on the back burner for now, however. The stock has better-than-average comeback potential to mid-decade, but the company’s earnings recovery no doubt will take a few years, and the issue may be more volatile than most stocks in the near term, given the concerns regarding mortgage foreclosure documentation, repurchase claims, and related litigation.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.